VISUAL PLANNED GIVING:
An Introduction to the Law and Taxation
of Charitable Gift Planning

12. CHARITABLE REMAINDER TRUSTS, PART 3 of 4

Links to previous sections of book are found at the end of each section.

A contribution to a Charitable Remainder Trust is required to have a minimum of 10% of the present value projected to go to charity at the termination of the trust. This requires that an amount significantly larger than 10% of the original amount be projected to go to charity at termination, because the charity is required to wait a substantial amount of time before receiving any funds. In other words, in order to generate a present value of 10%, the future value projected to go to the charity will necessarily be larger. Because the charitable income tax deduction resulting from a transfer to a Charitable Remainder Trust is the present value of the amount projected to go to charity (when the transfer is valued at fair market value), this means that the charitable income tax deduction for a transfer to charity must be at least 10% in such a case. If the amount projected to go to charity has a present value of less than 10% (when the transfer is valued at fair market value), the trust will not qualify as a Charitable Remainder Trust. This means that there will be no deductible gift. The general rule is that gifts where the donor keeps a retained interest of a different type than that given to charity are not deductible. The Charitable Remainder Trust is an exception to this rule. If a trust no longer qualifies as a Charitable Remainder Trust, then no exception applies and the gift is not deductible. Additionally, because the trust will no longer qualify as a charitable trust, it will be required to pay taxes on any realized capital gains or income resulting from trust investments. (In practice, such trusts can include language permitting the trustee to amend the trust – e.g., increasing the charitable share – for purposes of guaranteeing that the Charitable Remainder Trust rules are met.) Thus, it is essential that the trust is projected to give a large enough amount to charity that would generate at least a 10% tax deduction were the transfer to be valued at fair market value. It is important to note that all of these calculations are based upon the amount projected to go to charity. The amount that is actually transferred to charity is irrelevant to the tax calculation. This amount can be greater or less depending upon the return on the underlying investments and, in cases where the trust payments continue for a life or lives, the longevity of the annuitant.

The amount projected to go to charity – and the tax deduction based on the presentvalue of that amount – depend upon the longevity of the annuitant (who is typically the donor). The longer an annuitant lives, the longer a charity will have to wait to receive any funds. To the extent that the annual payments to annuitant(s) exceed the earnings of the trust, greater longevity will also result in a smaller nominal amount being left to the charity. (In the case of a Charitable Remainder Annuity Trust, it is possible for the trust to completely exhaust, leaving no money for the charity, because the payments remain the same regardless of the funds remaining in the trust. Total exhaustion of a unitrust is less likely because payments become smaller as the trust amount becomes less.)

The calculation used by the IRS to project the life expectancy of the annuitant systematically under-projects typical donor-annuitant life expectancy. Consequently, the tax deduction generated from transfers to Charitable Remainder Trusts is, actuarially, much larger than it should be. The source of this misprojection is that the IRS calculations are based upon normal life expectancy for a typical person of the annuitant’s age. However, donor-annuitants, on average, live much longer than typical people of their same age. This is due to three reasons.

First, annuitants self-select for health. In other words, people who know that they have a substantially greater risk of death generally don’t purchase annuities. Clearly, it makes no financial sense for a person with a known terminal illness to purchase a lifetime stream of payments. Because this “sick” group is largely excluded, the resulting life expectancy of annuity purchasers is, on average, longer. (Unlike the IRS, commercial annuity companies use a special life expectancy table when pricing commercial annuities that reflects this selection bias.)

Additionally, those who establish Charitable Remainder Trusts are typically quite wealthy. On average, wealthy people live longer than others of their same age. This may be due to factors such as the access to medical care and health promoting environments that money can purchase as well as physical and mental capabilities that help to both generate wealth and result in a longer life.

Finally, recent evidence suggests that those with charitable bequest plans live even longer than those of their same wealth decile (see American Charitable Bequest Demographics). Charitable Remainder Trusts typically make a transfer of the donor’s assets at the death of the donor, making them a form of general charitable bequest planning. The reason for this additional longevity among those with a charitable bequest plan has not been identified, but may relate to the importance of purpose and social connectedness in both giving and longevity.

The net result of this combination of factors is that donor-annuitants will live, on average, much longer than IRS projections. Consequently, donors will receive a larger tax deduction than might be justified by reality. One potential indicator of this reality is the share of Charitable Remainder Trust assets actually distributed to charity. In 2011, for example, Charitable Remainder Trusts held over $99 billion in assets, but made charitable distributions of only $1.9 billion, or less than 2% (Rosenmerkel, L. S., 2013, Split-Interest Trusts, Filing Year 2011, IRS Statistics of Income). Arguably, this may be a “temporary” experience due to the relatively recent establishment of some Charitable Remainder Trusts. However, given that such trusts were authorized in the tax code in 1969, to have such a small portion of assets going to charities some 42 years later suggests the potential for additional causes of this result, such as actuarially inappropriate valuations.

Both the Charitable Remainder Unitrust and the Charitable Remainder Annuity Trust are required to project that an amount with a present value of at least 10% of the initial transfer should go to charity at termination. However, the Charitable Remainder Annuity Trust has an additional requirement. Unlike a Charitable Remainder Unitrust, as the assets in a Charitable Remainder Annuity Trust grow smaller and smaller, the payment remains at its original dollar level. Because the payments do not become smaller as the assets in the Charitable Remainder Annuity Trust become smaller, there is a greater risk of total exhaustion of all funds in the Charitable Remainder Annuity Trust, especially where the annuitant lives much longer than expected. In the event of exhaustion, the donor would have enjoyed dramatic tax benefits with no actual charitable transfers ever taking place. This is a very bad result from the perspective of the goals of tax policy. To provide some protection against this disturbing outcome, a Charitable Remainder Annuity Trust will be disqualified if there is greater than a 5% chance of exhaustion due to annuitant longevity. As before, this calculation assumes that the trust will experience investment returns throughout its life equal to the §7520 rate at the creation of the trust.

There are two steps to determine whether or not there is a greater than 5% chance of exhaustion of a Charitable Remainder Annuity Trust due to the annuitant living much longer than expected. First, a standard time value of money calculation determines at what age the Charitable Remainder Annuity Trust would exhaust. Using a standard financial calculator this is done by solving for n (the number of time periods), after entering the interest rate (initial §7520 rate), present value (the initial transfer amount), payments per time period (the charitable remainder annuity payment), and a future value of zero (the point of exhaustion). This amount of time (n time periods) is added to the annuitant’s current age to identify the age at which the Charitable Remainder Annuity Trust would exhaust.

The next step is to determine if there is a greater than 5% chance that the annuitant will live to that age. This is determined simply by dividing the number of people alive at the annuitant’s projected age of exhaustion by the number of people alive at the annuitant’s current age, according to IRS Table 2000 CM. This table is located at www.irs.gov/Retirement-Plans/Actuarial-Tables, and the relevant numbers are labeled as Lx. If this ratio is greater than .05, the trust will not qualify as a Charitable Remainder Trust.

A trust intended to be a Charitable Remainder Trust can be disqualified for a number of reasons, such as being projected to leave too little to charity or having too great of a risk of exhaustion. But, what happens if the trust fails to qualify as a Charitable Remainder Trust under the tax code? A disqualified trust doesn’t just disappear. Its failure to comply with the tax requirements for a Charitable Remainder Trust typically won’t change the fact that the trust was created under state law, is irrevocable, and may be holding the assets transferred by the donor. So, what happens then?

Although the trust continues to exist as an irrevocable trust, it does not qualify for treatment as a Charitable Remainder Trust under federal tax law. Consequently all of the charitable tax benefits are lost. The donor receives no tax deduction for transferring assets to the trust. Additionally, the trust itself is not a tax-exempt entity. Thus, whenever the trust sells an appreciated asset, the trust must pay capital gains taxes on that sale. This means that the donor loses the ability to defer recognition of capital gains taxes. Whenever the trust earns income of other types, it must also pay taxes on that income. This means the trust can no longer grow assets in a tax-free environment. In fact, trusts are subject to a “compressed” tax rate schedule, meaning that trusts pay the highest marginal income tax rate (39.6%) at a much lower level of income ($12,301 in 2015) than individual taxpayers do. As a result, the disqualification of a Charitable Remainder Trust would be a tax disaster for most donors. Because of this dramatically negative result, such trusts are typically drafted with language that allows the trustee to amend the terms of the otherwise irrevocable trust if such changes are required to allow the trust to qualify as a Charitable Remainder Trust under the federal tax law.

We have considered the charitable income tax deduction generated for the donor transferring funds to a Charitable Remainder Trust, and the tax treatment of gains recognized or income earned by the trust itself. There is one additional source of tax consequences for transfers to a Charitable Remainder Trust. This comes from the payments made from the Charitable Remainder Trust to the annuitant(s). When an annuitant receives a payment from the Charitable Remainder Trust, how should the annuitant report the payment on his or her taxes?

The tax treatment of payments coming to an annuitant depends in part on the tax characteristics of the money held by the Charitable Remainder Trust. The trust may be holding a variety of asset types including ordinary income, capital gain, exempt income, and initial principal (e.g., the basis in property initially transferred to the trust). So when a trust is holding all of these types of assets, how do we determine which asset type the annuitant receives? The fundamental rule is referred to as “worst in, first out” (WIFO). In other words, the annuitant receives the asset type that would normally generate the highest tax rates first. Assets with lower tax rates will be distributed only after there are no remaining assets with higher tax rates.

An easy way to visualize this rule is to think of the Charitable Remainder Trust assets as liquid inside a water cooler where the assets with the heaviest taxation are on the bottom and those with lighter taxation at progressively higher levels. When a payment is made from the trust, it is like opening the spigot at the bottom of the water cooler. The liquid with the heaviest taxation comes out first, and those with lighter taxation will come out only after those assets with heavier taxation have been completely drained. For example, all ordinary income will be paid out before any capital gain income. All capital gain income will be paid out before any tax exempt income. And distribution of tax-free return of principal will occur only when there are no other types of assets to distribute.

Let’s consider an example to demonstrate how the WIFO (worst in, first out) rule works. Suppose a donor gives $100,000 of stock, which she initially purchased for $10,000, to a Charitable Remainder Trust. After receiving the stock, the Charitable Remainder Trust trustee sells the stock for $100,000 and buys corporate and municipal bonds. During the first year of the trust, the corporate bonds generate $3,000 of income and the municipal bonds generate $2,000 of tax exempt income. Assuming that the Charitable Remainder Trust makes annual payments, what type of assets will be included in the trust at the end of the first year when the first payment is about to be made? The donor’s $10,000 basis is included in the trust as an asset that could be paid to the annuitant as tax-free return of investment. At the next level, the trust has earned $2,000 of tax-exempt income from its investments in municipal bonds. Next, the trust has $90,000 in capital gains from the sale of the stock for $100,000 (because the stock was purchased by the donor for $10,000). Finally, the trust has $3,000 of ordinary income earned from the corporate bond investments. The trust itself is a tax-exempt entity. Thus, the trust pays no taxes on any capital gain or income earned. However, if capital gain or ordinary income is distributed to an annuitant, then the annuitant will be taxed on that distribution based on the type of income/gain being distributed.

Suppose this Charitable Remainder Trust were required to pay $2,000 to the annuitant. How would the annuitant report this $2,000 payment on her taxes? In this case, the trust is holding $3,000 of ordinary income (earned from its investment in corporate bonds). Because all ordinary income must be paid out prior to the payment of other types of income, the entire $2,000 payment will count as ordinary income to the annuitant.

Suppose instead that the Charitable Remainder Trust were required to distribute $5,000 to the annuitant. How would the annuitant report this $5,000 on her tax return? Because the trust is holding $3,000 of ordinary income (earnings from the interest payments on corporate bonds), this amount must be paid out first. The remaining $2,000 would be paid from the $90,000 of capital gain held by the trust. The ordinary income is paid first because it normally receives the worst tax treatment (i.e., it generates the highest tax rates for the typical taxpayer). The capital gain is paid next because it is worse than either exempt income from the municipal bonds or tax-free return of investment from the donor’s basis in the gifted property.

The WIFO concept (worst in, first out) dictates that all capital gain must be paid out before any payments are made from the exempt income or original basis. Thus, the distributions to annuitants would have to completely pay out all $90,000 of capital gain income to the annuitant before the annuitant could receive any form of exempt income or tax-free return of basis. Thus, it likely would make no sense for this particular Charitable Remainder Trust to invest in municipal bonds. The tax-exempt nature of municipal bonds does not affect the Charitable Remainder Trust itself, because the Charitable Remainder Trust is a tax-exempt entity and pays no tax on income earned. The tax-exempt nature of municipal bonds could benefit the annuitant if this tax-exempt income were paid to the annuitant, but such payments are highly unlikely, given the relatively large amount of capital gain yet to be distributed.

There are, of course, other more detailed distinctions in income type than those presented in this example. However, where the tax treatment of assets differs, the general WIFO rule typically applies. Thus, investment income recognized prior to December 31, 2012 – and thus not subject to the 3.8% healthcare surtax – would be paid out only after similar income earned after 2012. Similarly, a capital gain recognized after 2012 (and subject to the additional tax) would be paid out prior to any capital gain recognized in 2012 or earlier.

This tax treatment of distributions from Charitable Remainder Trusts means that capital gains taxes deferred through the use of a Charitable Remainder Trust might never be paid. If the trust’s total ordinary income earnings are greater than its distributions, then no capital gains payments will ever be made. In this way the capital gains tax deferral can very often become complete capital gains tax avoidance.

In contrast, a Charitable Gift Annuity purchased with appreciated property can defer recognition of the capital gain, but will not avoid the tax. Conceptually, this could be phrased as a benefit of the Charitable Remainder Trust because the trust offers not just capital gains tax deferral but actual capital gains tax avoidance. But, in reality, the Charitable Remainder Trust annuitant avoids the capital gains tax only by paying the higher ordinary income tax. As compared with purchasing a Charitable Gift Annuity with appreciated property, the “advantage” of capital gains tax avoidance means paying higher ordinary income tax and never receiving tax-free return of investment.

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Comments

Good discussion of the taxation of CRUT and CRAT payments to income beneficiaries. But how might this tax treatment differ for net-income CRTs (whether with makeup balance or not)? What are the tax implications when there is tax-exempt income in a NIMCRUT? Does all income retain its tax characteristics when distributed to income beneficiaries? If so, could there thus be tax-exempt income paid to income beneficiaries before pent-up capital gains need be paid out?

Randy's comments are spot on. I like to think of it as a "worst in, first out" system, so the worst (i.e.,typically highest taxed) income you earn will be the first to be paid out. Consequently, tax exempt income, like that from municipal bonds, won't come out until after all the capital gain has been paid out, which might be never.

NIMCRUTs and NICRUTS are still taxed under the four tier system. Since ordinary income and capital gain must be paid before exempt income, it's possible to make a serious mistake by investing in exempt assets before the captured capital gains are exhausted.